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May 23, 2013

The Outlook for High-Yield Bonds: High Income or High Risk?

One of the really bright spots in the investment universe over the last few years has been the high-yield bond market.

Since rates began falling in the wake of the 2008 financial crisis,global demand for higher-yielding assets has been steadily rising. This demand has outstripped supply to drive prices higher and yields lower. At this point, after four years of a bull market in the asset class, it’s reasonable to ask if high-yield bond buyers are still being adequately rewarded for their investment risk. Based on a review of key statistical data, along with our conversations with key bond market players, we’re willing to suggest they are, at least to a degree. Here’s why we think signs point to a marginally positive outlook for the broader non-investment grade asset class.

Measured Risk

From a fundamental perspective, the financial strength of issuing companies within the U.S. high-yield market remains fairly strong. Strong enough, in fact, that the 12-month rolling default rate in the high-yield market has remained around a historically low 2% since 2008. Not surprisingly, issuers in the space have taken advantage of their solid balance sheets to refinance pre-2008 debt at today’s significantly lower rates. This debt restructuring is somewhat of a double-edged sword for investors, of course, in that the lower annual debt service decreases the likelihood of default but at the same time results in smaller coupon payments.

In the meantime, low levels of merger and acquisition activity have been supportive of these quality fundamentals. In general, M&A activity creates additional bond supply but it means shakier balance sheets as well. Interestingly, despite high levels of anticipation, deal levels remain historically low.

Measurable Reward

So given its reasonably strong fundamentals, what is the relative value of the high-yield market versus its investment-grade competition? The answer is positive but mixed. The chart below shows the Barclays U.S. Corporate High Yield Index’s option adjusted spread (OAS) over similar maturity Treasuries and yield-to-worst (YTW) over the past two decades. An examination of the chart shows that the high-yield OAS has fallen from a whopping 1,800 basis points at the height of the 2008 crisis to just over 450 basis points today, very near the median level of spreads over the last 20 years. Since spreads over Treasuries have moved and remained lower for years at a time, it can be inferred there is some room for further spread compression and capital gains for high yields going forward.

The YTW analysis produces more mixed signals. (YTW assumes bonds with call provisions or other prepayment options get called at the worst possible time for investors.) The chart above shows the current YTW to be not only at its lowest point ever, but nearly 400 basis points below the median level over the last two decades. In practical terms, this means investors are earning less than 6% on the broad high-yield Index.

So while spreads are in line with the long-term median levels and have room for further compression, any such drop in spreads would further reduce absolute yields from already historic lows.

Reasonable Expectations

Taken together, it is clear there are still good reasons to invest in non-investment-grade corporate bonds. Today’s high-yield environment offers higher current income than any fixed-income alternative—we can see the current 4.5% OAS versus Treasuries, and there is a nearly 3% spread versus investment-grade corporates on a YTW basis (based on a YTW on the Barclays Corporate Index of 2.76% as of March 31, 2013).

At the same time, we know that fixed income portfolio managers are looking for little change in overall high-yield default rates over the next 12 months. All in, expectations are for below-average total returns compared to the long term, but well ahead of the investment grade indexes.

To the question, then: Do high-yield bonds mean high yield or high risk? Relatively speaking, it means both, just less pronounced than in the past. But that’s okay. While absolute income expectations should be lowered for the foreseeable future, the asset class still offers a fair to slightly positive risk/reward profile.

Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.